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The Bruce Column — Cluttering up the materiality arguments

19 Apr 2011

It is the glib response. The sight of a 52-page booklet arriving on your desk bearing the title 'Cutting Clutter' could result in you, with unerring aim, tossing the thing over your shoulder into the recycling bin and following that up with a triumphant shout of: 'Job Done!'

This would be a mistake. The booklet from the UK Accounting Standards Board is the latest in a series of broadsides under the aegis of the Financial Reporting Council. Previous publications have torn into the nonsense which clogs up the official channels of financial reporting. This one looks at why people find it hard to get rid of clutter and offers advice on how to change the behaviours which lead to its clogged accumulation. The obvious problem is, of course, lawyers, and others.

'Opinions provided by internal teams, (for example, in-house lawyers), and external auditors tend to focus on what to put in, not what to take out, in order to ensure that the financial statements comply with every disclosure', it warns. And this is understandable, if not excusable. No one is going to get shouted at for putting too much in. But if they leave something out, which with hindsight proves a disastrous omission later on, they could be in deep trouble.

But the FRC wants to concentrate on behaviours. This works both ways. Preparers mind their backs and put stuff in, whether it is material or not, and regulators and standard-setters come up with yards of stuff which turns into good old tick-box checklists. And, when preparers were asked why immaterial clutter finished up in their annual reports, they came up with a worrying variety of reasons.

All of these are, to a greater or lesser extent, easily avoided. And all come about because no one is trying to change the process. They are simply seeking to conform to the process. Just look through the commonest reasons given: 'Due to time pressures, preparers simply repeat disclosures made in prior years rather than considering whether they are still material'. Or: 'Lack of confidence in making the judgement between disclosures that are material and those that are not'. Or: 'Just as much work being required to conclude on materiality as to prepare the disclosure'. Or, and you can feel the depth of experience which underscores this one: 'Desire to avoid lengthy debates with the auditors'. Or: 'Following the leader: if another company makes a disclosure, it can influence others to follow'. Or: 'Fear that a missing disclosure will be challenged by regulators'.

The motives behind all of those are understandable. But almost all of them are based on some sort of stagnation in the corporate organisation. So go back to the starting point. IAS1 states that: 'An entity need not provide a specific disclosure required by an IFRS if the information is not material'. Yet everybody does. What happens in the section on share-based payments? Someone presses the 'regurgitate at great length' button and the whole lot downloads onto the pages of the financial statements. Almost no one can then see the wood for the trees. The detail drives out any possibility of understanding. And it is not just in the sections which are directly influenced by IFRS that all this happens. Sustainability reporting is notorious. And, as the report notes, 'one of the potential reasons for this is social pressure making it difficult for a company to disregard CSR areas, regardless of the importance of each area to its particular business'. Same problem, same reason. No one is thinking.

What the FRC wants the IASB to do is to clarify materiality. It wants to 'encourage the IASB to clarify what materiality means from a disclosure perspective'.

What the FRC wants from preparers stems from feedback suggesting that 'preparers simply provide all the prescribed disclosures about every single share scheme whatever the scheme's size and impact'. As an example of tick-box behaviour the FRC wants changed, it has singled out disclosures about share-based payments for particular criticism. They have gone so far as to creating a disclosure aid for companies. This aims to encourage preparers to 'disaggregate the cost of share-based payment schemes; make full disclosure only about those schemes that are material; and provide only brief details of immaterial schemes'. And the template they provide for how this would work in the notes to the accounts shows how it could be put into practice. The end result would become clearer and it would help companies limit their reputational risk in the coming arguments brewing up over the scale of executive remuneration.

Ultimately, it all comes down to one issue. Producing financial information is seen as a grinding process-driven exercise rather than an opportunity to illuminate the thoughts and decision-making of investors. The FRC understands this and the clutter-cutting effort deserves thought rather than offhand dismissal. Changing behaviours needs a change in motivation. It is no surprise that the best sections of 'Cutting Clutter' are all about how to insert steps into the process which would put an anti-clutter detection and elimination mechanism into all planning stages of the financial reporting process.

Robert Bruce
April 2011

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